Editor: Greg A. Fairbanks, J.D., LL.M.
For multinational taxpayers, the tax paradigm has shifted due to the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, and related regulatory developments. One consequence of these international tax changes is that the ability to claim a foreign tax credit (FTC) has arguably never been more important than it is today. Historically, the U.S. tax system has provided taxpayers the ability to claim an FTC with respect to income taxes paid in a foreign jurisdiction, subject to various limiting factors. The TCJA made numerous changes to U.S. tax law that increase the utility and importance of an FTC. These systemic changes materially impact the determination of how much credit can be claimed by a taxpayer in any given year and may present planning challenges for taxpayers with taxable income inclusions resulting from global intangible low-taxed income (GILTI) or Subpart F, for example.
FTC proposed regulations (REG-101657-20) issued by the IRS and Treasury on Sept. 29, 2020, (the 2020 proposed regulations) introduce sweeping guidance with implications that could result in substantially different future FTC outcomes for impacted taxpayers. While the 2020 proposed regulations address a wide range of FTC issues, this discussion focuses primarily on one aspect: how the new rules would affect taxpayers' ability to claim FTCs for foreign income taxes that are offset with refundable tax credits in a foreign jurisdiction.
In many cases, multinational groups may claim tax credits in one or more foreign jurisdictions related to, for example, conducting research activity or investing in certain types of technology. Often, the credits being claimed offset a taxpayer's local jurisdictional income tax liability as opposed to being paid to the taxpayer in cash. Certain types of credits are limited as to their amount by taxable income or based on some other income tax—related measure. Other credits, however, are refundable in cash to the extent there is no income tax (or other tax) to offset, and sometimes at the election of the taxpayer. These latter credits are generally referred to as "refundable" credits and present challenging FTC questions.
FTC regime pre-TCJA: In general, eligible taxpayers may elect to offset U.S. income taxes incurred on their net foreign-source income by creditable foreign tax paid or accrued on such income. Sec. 901(b)(1) provides that a U.S. taxpayer may claim a credit for "the amount of any income, war profits, and excess profits taxes paid or accrued during the taxable year to any foreign country or to any possession of the United States." Regs. Sec. 1.901-2(a)(1) further provides that to be a creditable tax, a foreign levy must be a tax with the predominant character of an income tax in the U.S. sense.
In determining whether foreign taxes qualify for purposes of the FTC, the rules under Sec. 901 provide that the amount must have been paid or accrued by the taxpayer. Regs. Sec. 1.901-2(e)(2)(i) provides that an amount is not tax paid or accrued to a foreign country to the extent that it is reasonably certain that the amount will be refunded, credited, rebated, abated, or forgiven. Further, Sec. 904 applies a complex set of limitations to an FTC, which is calculated separately for various categories of foreign-source income. Under certain circumstances, a U.S. corporation also may have been entitled to a "deemed paid" credit for its share of foreign taxes paid by certain related corporations.
FTC regime post-TCJA: The TCJA made numerous changes to U.S. tax law that impact the FTC rules. It implemented the dividend-received deduction under Sec. 245A, added new FTC limitation categories, repealed the "deemed paid" FTC provision under Sec. 902, and modified the deemed-paid FTC under Sec. 960. Most notably, the TCJA added Sec. 951A (GILTI), which subjects a U.S. shareholder of a controlled foreign corporation (CFC) to current taxation on certain foreign income.
For tax years beginning after 2017, a U.S. shareholder of a CFC is subject to current U.S. tax on its GILTI inclusion. GILTI is generally defined as the excess of a U.S. shareholder's aggregated "net tested income" from CFCs over a routine return on certain qualified tangible assets. Tested income is the excess, if any, of the corporation's gross income (without regard to certain items) over its deductions allocable to that gross income.
Generally, under Sec. 951A, a corporation can deduct 50% of its GILTI and claim an FTC for 80% of foreign taxes paid or accrued on GILTI. Thus, if the foreign tax rate is zero, the effective U.S. tax rate on GILTI will be 10.5% (half of the regular 21% corporate rate because of the 50% deduction). If the foreign tax rate is 13.125% or higher, application of the FTC will offset or potentially limit the U.S. tax owed on a U.S. corporate shareholder's GILTI. Consequently, for many taxpayers the FTC serves to dampen the negative effects of the GILTI regime.
The TCJA also expanded the separate limitation categories with respect to the FTC limitation. In addition to the passive category income and general category income baskets, the TCJA under Sec. 904(d) added two new income baskets for determining amounts attributable to inclusions of GILTI under Sec. 951A and foreign branch income. Therefore, for tax years beginning after Dec. 31, 2017, Sec. 904(d)(1) now provides four limitation categories: (1) any amount includible in gross income under Sec. 951A (other than passive category income); (2) foreign branch income; (3) passive category income; and (4) general category income. Note that an FTC attributable to the GILTI basket provides no carryback or carryforward for excess credits not used in the period of the GILTI inclusion.
The amendments under Sec. 951A have significantly changed the rules governing FTCs and undoubtedly heightened the importance of determining the FTC in the post-TCJA world. Pre-TCJA, many taxpayers may have been less reliant on the FTC to reduce their U.S. tax liability. Most foreign income earned by CFCs was not subject to U.S. taxation until repatriated or included under an anti-deferral regime like Subpart F. As a result, post-TCJA taxpayers may find themselves much more focused on their FTC posture and planning.
Recent developments in the 2020 proposed regulations only serve to reinforce the complexity of the FTC regime. Specifically, the 2020 proposed regulations, if finalized, would substantially change certain long-standing pillars of the FTC regime, including impacting the amount of creditable foreign taxes available to U.S. taxpayers.
Impact of the 2020 proposed regulations
Refundable FTCs as a constructive payment of cash: As previously discussed, under Sec. 901, a taxpayer must both owe and remit the foreign income taxes to be eligible for an FTC. The existing regulations provide rules for determining the amount of foreign tax that is considered paid and eligible for credit under Sec. 901. The 2020 proposed regulations clarify in several respects the amount of tax that is considered paid (or accrued) and eligible to be creditable against U.S. tax, subject to the Sec. 904 limitations.
In determining whether foreign taxes qualify as creditable for purposes of the FTC, the existing regulations provide that a payment to a foreign country is not treated as an amount of tax paid to the extent that it is reasonably certain that the amount will be refunded, credited, rebated, abated, or forgiven. Nevertheless, the IRS has afforded taxpayers exceptions in several situations where the credit provided by the foreign jurisdiction is a refundable amount. For example, in Technical Advice Memorandum (TAM) 200146001 the IRS concluded that a research credit offered by the French government did not reduce the pool of taxes available to be claimed as an FTC at the time a dividend was distributed to a U.S. parent company.
In the TAM, the taxpayer originally reduced its pool of creditable taxes by the amount of a French research credit (as if it had received a refund of French taxes paid). Subsequently, the taxpayer amended its tax returns to claim additional FTCs, believing that it was not required to reduce its pool of creditable taxes. The IRS ruled that the research credit was a means of payment by the French government because the taxpayer received the credit from the French government in either cash or as an offset against future liability. Consequently, the taxpayer was entitled to consider those credits and eligible foreign taxes in the United States for FTC purposes. In the TAM, the IRS focused on the refundable nature of the credit and agreed that it was not a reduction in tax but instead additional income to the taxpayer that was used to pay its tax lability.
In IRS General Counsel Memorandum 39617, the IRS considered whether investment incentives, called WIR premiums, granted by the Netherlands should be treated as reducing Netherlands income taxes paid or accrued for purposes of the U.S. FTC. By way of background, the WIR premium incentive was amended by the Netherlands in 1986. Prior to 1986, taxpayers were permitted to offset their WIR premium benefit against income tax, with any excess being refundable to the taxpayer. However, for years after the law change was enacted, the benefit of the premiums would continue to offset income tax liability but would no longer be refundable beyond the current-period income tax. Carryforwards and carrybacks were permitted but only to the extent of income tax in the period to which the credits were carried. The WIR premium incentive was calculated by reference to the level of investment in qualifying Dutch assets by the Dutch taxpayer.
In this case, the IRS determined that for the years in which the taxpayer could only claim WIR premiums through a credit or offset against Netherlands income tax assessment, the amount of tax offset by the premium credit was not eligible to be credited in the United States. However, the IRS also determined for years in which the credit was "refundable," the amount of the benefit should be considered taxes paid and thus qualify for the U.S. FTC.
These authorities, read in context of the statute and regulations, provide support for the position that a local tax could be considered paid, and thus creditable against U.S. tax, even if it is offset by a "refundable" tax credit. As a result, U.S. multinational taxpayers operating in a country with refundable credits may have an opportunity to increase their U.S. FTC, while at the same time paying less in cash taxes in the respective country. Such a taxpayer foreseeably could also reduce its overall effective tax rate for financial reporting purposes. However, the 2020 proposed regulations, if finalized, may alter this outcome.
Refundable FTCs and the 2020 proposed regulations: The preamble to the 2020 proposed regulations now indicates that the law is unclear in this area, including as to whether credits allowed under foreign tax law that are computed with reference to amounts other than foreign tax payments (such as investment or R&D tax credits) may be treated as a constructive receipt of cash by the taxpayer from the foreign country, followed by a constructive payment by the taxpayer of foreign income tax. The preamble points out that the "results have sometimes differed depending on whether the credit is refundable under foreign law, that is, whether taxpayers are entitled to receive a cash payment from the foreign country to the extent the credit exceeds the taxpayer's foreign income tax liability."
Citing the need for a "clear rule" regarding the treatment of tax credits, the 2020 proposed regulations provide that foreign income tax is not considered paid if it is reduced by a tax credit, regardless of whether the amount of the tax credit is refundable in cash. The intent of this rule is to provide certainty on the treatment of credited amounts. Thus, an amount allowed as a credit would not be treated as a constructive payment of cash from the foreign country followed by a constructive payment of the tax, even if the creditable amount is refundable in cash to the extent it exceeds the taxpayer's liability for the tax that is reduced by the credit.
The 2020 proposed regulation under Regs. Sec. 1.901-2(e)(2)(ii) leaves many unanswered questions for taxpayers claiming foreign government tax credits or other assistance, such as grants or support payments. It would appear that the design and mechanics of the particular incentive or credit will play an important role in determining whether amounts credited can be considered foreign taxes paid or accrued. Consider a foreign taxpayer who, in connection with a local credit regime, receives cash payments and uses that cash to pay its income tax. Is this taxpayer really economically different from a taxpayer who gets a decrease in its foreign tax liability as a result of the credit, with a refund available for any overage? If the 2020 proposed regulations are finalized, those taxpayers, while largely indistinguishable from an economic standpoint, may have completely different U.S. tax results stemming from the FTC impacts.
The proposed regulations also address several other aspects related to FTCs, including the treatment of payments as noncompulsory payments, jurisdiction nexus requirements, as well as other pertinent issues related to the amount of FTC that can be claimed.
Risk and opportunity
In the wake of the TCJA, the treatment of refundable FTCs represents an important risk and opportunity for taxpayers claiming them. As discussed, under certain circumstances the refundable credits claimed may represent an opportunity to reconsider the available amount of FTCs that can be used to offset U.S. tax on foreign income, including tax on GILTI and Subpart F inclusions. On the other hand, in some circumstances, the benefit of claiming a refundable tax credit in a foreign jurisdiction may be offset, in whole or part, by the operation of U.S. tax systems such as GILTI and Subpart F.
If finalized in their current form, the 2020 proposed regulations would alter the interpretation of the current authorities that support the notion that refundable tax credits used to reduce foreign tax should nonetheless represent creditable foreign taxes. In other words, the 2020 proposed regulations would prospectively limit taxpayers' ability to rely on current administrative guidance as it relates to these FTCs and the associated U.S. benefits.
Assuming the 2020 proposed regulations are finalized sometime in 2021, they would apply for tax years beginning after the date on which they are finalized. Accordingly, the treatment of refundable FTCs under current law would appear viable only for tax years through 2021, assuming, again, that the regulations are finalized in 2021. This means U.S. multinationals operating in countries with refundable credits may be forced to reduce their claim for a U.S. FTC to the extent foreign taxes are paid with refundable credits. With this in mind, taxpayers would be prudent to assess how the 2020 proposed regulations would affect their specific tax circumstances. Taxpayers who, in tax years preceding the application of these proposed regulations, have not credited foreign income taxes that were offset by local refundable tax credits may consider amending their returns to claim those credits.
Greg A. Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington.
For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or firstname.lastname@example.org.
Contributors are members of or associated with Grant Thornton LLP.